Category: Economics

Ben Bernanke is best known for being Fed chairman, but he has a long and distinguished research career of great influence.  Here are some of his contributions:

1. In a series of papers, often with Alan Blinder, Bernanke argued that “credit and money” are a better leading indicator than money alone.  And more generally he helped us rethink the money-income correlation that was so promoted by Milton Friedman.  This work was more correct than not, but since money as a leading indicator has fallen out of favor (partially because of Bernanke’s own later actions!), these contributions are seen as less important than was the case for about fifteen years.  See also this piece on the (earlier) import of the federal funds rate as a measure of monetary policy.  Ben’s body of work on money and credit was what first brought him renown.

2. Bernanke has a famous 1983 paper on how the breakdown of financial intermediation was a key component of the Great Depression.  Earlier, Milton Friedman had stressed the import of the contraction of the money supply, but Bernanke’s work led to a much richer picture of how the collapse happened. Savers were cut off from borrowers, due to bank failures, and the economy could not mobilize its capital very effectively.  This article also shows the integration between Bernanke’s work and that of Diamond and Dybvig.  This piece has held up very well.

3. Bernanke has related work, with Gertler, Gilchrist and others, on how financial problems can worsen a business cycle.  This work of course fed into his later decisions as chairman of the Fed.  In yet other work, Bernanke showed how economic downturns can lower the value of collateral, thus squeezing the lending process and exacerbating business cycle downturns.

4. Bernanke’s doctoral dissertation was on the concepts of option value and irreversible investment.  Modest increases in business uncertainty can cause big drops in investment, due to the desire to wait, exercise “option value,” and sample more information.  This work was published in the QJE in 1983.  I have long felt Bernanke does not receive enough credit for this particular idea, which later was fleshed out by Pindyck and Rubinfeld.

5. Bernanke wrote plenty of pieces — this one with Mishkin — on inflation targeting as a new means of conducting monetary policy.  Those were the days!  Much of the OECD lived under this regime for a few decades.

6. Here is Ben with co-authors: “We first document that essentially all the U.S. recessions of the past thirty years have been preceded by both oil price increases and a tightening of monetary policy…”  Uh-oh!

7. Here is 2004 Ben on what to do when an economy hits the zero lower bound.  Here is Ben on earlier Japanese monetary policy, and what he called their “self-induced paralysis” at the zero bound.  He really was in training for the Fed job all those years.  Here is Ben on “The Great Moderation.”  Here is 1990 Ben on clearing and settlement during the 1987 crash.

8. Ben has made major contributions to our understanding of how the gold standard and international deflationary pressures induced the Great Depression, transmitted it across borders, and made it much worse.  This work has held up very well and is now part of the mainstream account.  And more here.

9. Bernanke coined the term “global savings glut.”

Here is all the Swedish information on the researchers and their work.  I haven’t read these yet, but they are usually very well done.  Here is Ben on scholar.google.com.

In sum, Ben is a broad and impressive thinker and researcher.  This prize is obviously deserved.  In my admittedly unorthodox opinion, his most important work is historical and on the Great Depression.

The Diamond and Dybvig model was first outlined in a seminal paper from Douglas W. Diamond and Philip H. Dybvig in 1983 in a famous Journal of Political Economy piece, “Bank Runs, Deposit Insurance, and Liquidity.”  You can think of this model as our most fundamental understanding, in modeled form, of how financial intermediation works.  It is a foundation for how economists think about deposit insurance and also the lender of last resort functions of the Fed.

Here is a 2007 exposition of the model by Diamond.  You can start with the basic insight that bank assets often are illiquid, yet depositors wish to be liquid.  If you are a depositor, and you owned 1/2000 of a loan to the local Chinese restaurant, you could not very readily write a check or make a credit card transaction based upon that loan.  The loan would be costly to sell and the bid-ask spread would be high.

Now enter banks.  Banks hold and make the loans and bear the risk of fluctuations in those asset values.  At the same time, banks issue liquid demand deposits to their customers.  The customers have liquidity, and the banks hold the assets.  Obviously for this to work, the banks will (on average) earn more on their loans than they are paying out on deposits.  Nonetheless the customers prefer this arrangement because they have transferred the risk and liquidity issues to the bank.

This arrangement works out because (usually) not all the customers wish to withdraw their money from the bank at the same time.  Of course we call that a bank run.

If a bank run occurs, the bank can reimburse the customers only by selling off a significant percentage of the loans, perhaps all of them.  But we’ve already noted those loans are illiquid and they cannot be readily sold off at a good price, especially if the banks is trying to sell them all at the same time.

Note that in this model there are multiple equilibria.  In one equilibrium, the customers expect that the other customers have faith in the bank and there is no massive run to withdraw all the deposits.  In another equilibrium, everyone expects a bank run and that becomes a self-fulfilling prophecy.  After all, if you know the bank will have trouble meeting its commitments, you will try to get your money out sooner rather than later.

In the simplest form of this model, the bank is a mutual, owned by the customers.  So there is not an independent shareholder decision to put up capital to limit the chance of the bad outcome.  Some economists have seen the Diamond-Dybvig model as limited for this reason, but over time the model has been enriched with a wider variety of assumptions, including by Diamond himself (with Rajan).  It has given rise to a whole literature on the microeconomics of financial intermediation, spawning thousands of pieces in a similar theoretical vein.

The model also embodies what is known as a “sequential service constraint.”  That is, the initial bank is constrained to follow a “first come, first serve’ approach to serving customers.  If we relax the sequential service constraint, it is possible to stop the bank runs by a richer set of contracts.  For instance, the bank might reserve the right to limit or suspend or delay convertibility, possibly with a bonus then sent to customers for waiting.  Those incentives, or other contracts along similar lines, might be able to stop the bank run.

In this model the bank run does not happen because the bank is insolvent.  Rather the bank run happens because of “sunspots” — a run occurs because a run is expected.  If the bank is insolvent, simply postponing convertibility will not solve the basic problem.

It is easy enough to see how either deposit insurance or a Fed lender of last resort can improve on the basic outcome.  If customers start an incipient run on the bank, the FDIC or Fed simply guarantees the deposits.  There is then no reason for the run to continue, and the economy continues to move along in the Pareto-superior manner.  Of course either deposit insurance or the Fed can create moral hazard problems for banks — they might take too many risks given these guarantees — and those problems have been studied further in the subsequent literature.

Along related (but quite different!) lines, Diamond (solo) has a 1984 Review of Economic Studies piece “Financial Intermediation and Delegated Monitoring.”  This piece models the benefits of financial intermediation in a quite different manner.  It is necessary to monitor the quality of loans, and banks have a comparative advantage in doing this, relative to depositors.  Furthermore, the bank can monitor loan quality in a diversified fashion, since it holds many loans in its portfolio.  Bank monitoring involves lower risk than depositor monitoring, in addition to being lower cost.  This piece also has been a major influence on the subsequent literature.

Here is Diamond on google.scholar.com — you can see he is a very focused economist.  Here is Dybvig on scholar.google.com, most of his other articles in the area of finance more narrowly, but he won the prize for this work on banking and intermediation.  His piece on asset pricing and the term structure of interest rates is well known.

Here is all the Swedish information on the researchers and their work.  I haven’t read these yet, but they are usually very well done.

Overall these prize picks were not at all surprising and they have been expected for quite a few years.